The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Friday, January 14, 2011

Bank Capital and Bank Runs

In order to answer the question of "what is the appropriate level of capital" for a bank, it is important to understand the phenomenon known as a run on the bank.

One of the core businesses of a bank is financial maturity transformation. On the one hand, banks take in short term deposits. On the other hand, they lend out the money in longer term loans.

Critical to the willingness of the depositor to put their money into the bank is the belief that they will get all of their money back. The cause of bank runs is that this belief is undermined.

Depositors know that banks have a limited amount of cash available. If the depositor thinks that the bank is no longer capable of returning their money as a result of losses from the asset side of the bank balance sheet, they have an incentive to run down to the bank to see if they can get their money back first. Hence, the reason this phenomenon is referred to as a run on the bank.

The important point to remember about bank runs is that they are triggered by a change in the belief of a depositor that they will get their money back. This can occur even today with deposit insurance and central banks standing ready to lend against good collateral. Look at what happened to Lehman Brothers and the Irish banking system.

Can the phenomenon of bank runs be stopped? Yes.

Economists and regulators have proposed that the solution to stopping bank runs can be found in the amount of capital that banks hold. In their view, capital is there to absorb losses and the higher the capital ratio, the safer the depositor would be.

Laurence Kotlikoff, a professor at Boston University, takes the idea of holding capital to its logical extreme. He proposes limited purpose banks. These limited purpose banks, which are equivalent to closed-end mutual funds, would have capital equal to assets. By definition this ends the potential for bank runs as there is no leverage and no depositors. This idea has caught the attention of the Bank of England and the UK Independent Banking Commission.

At the other end of the percentage of capital held spectrum and fighting to protect its turf is the banking industry. Shockingly, it would like to hold a smaller percentage of capital so as to generate a higher return on equity and the related compensation. The industry has generated a variety of arguments in support of lower capital requirements. These include the idea that raising capital requirements would restrict the availability of credit and that it turn could undermine the fragile recovery from the financial crisis. In addition, banks would naturally have to increase the cost of credit as the equity is more expensive than debt.

Close to the position of the industry are the regulators. They have staked out the position that enhancing capital requirements will prevent another financial crisis. Under the recently announced Basel III capital requirements, capital must increase from 4-6% of assets to 7-10% of assets. For its part, the Swiss banking regulator took into consideration how difficult it was for the country to support its banking industry and decided that going forward it would require twice this level of capital.

Without going to Professor Kotlikoff's limited purpose banks and fundamentally restructuring the financial system, is there a bank capital ratio that by itself would stop the phenomenon of bank runs?

No.

The psychology of bank runs is driven by the change in belief about the ability of the depositor to get 100% of their money back. Absent any facts, depositors come to believe that the losses on the bank's assets exceed the bank's capital. Hence the incentive to race to the bank to withdraw funds.

The only way to effectively stop this psychology of bank runs is by making information available that would allow a depositor to answer the question of "does the bank currently have enough capital to cover the losses on its assets?"

If current asset-level data were available, depositors could determine for themselves, or rely on credit and equity market analysts to determine for them, that the bank with their deposits is solvent. Knowing that the bank is solvent would stop the need for the depositor to run to get their assets back.

Current asset-level data could be combined with Basel III regulatory requirements to effectively eliminate runs on the bank in the future.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.